What recovery from COVID-19 could look like

Investors are probably not the most esteemed sources of analysis when it comes to disease outbreaks. But history shows that outbreaks have been inevitably brought under control, often via human behaviour. The SARS outbreak lasted nine months, swine flu lasted eight months, and MERS outbreaks have typically taken several months to contain, as in South Korea.

COVID-19’s contagiousness and relatively long (asymptomatic) incubation period make this a challenging pandemic to contain, as evidenced by more than 1.2 million cases around the world (and more than 70,000 fatalities). The full weight of the global medical technology sector is being applied to discovering a vaccine and Peter Doherty from The Doherty Institute in Australia says a COVID-19 vaccine could be available within 12 to 18 months.

At Crestone, we have been scenario-testing the three different recoveries you may have heard investors refer to as U-, V- and L-shaped recoveries.

U-shaped recovery

This is our central case, with a 50 per cent probability. Here the first-half confirms a sharp mid-2020 collapse in activity and earnings. For most countries, growth in the second and third quarters contracts and Purchasing Managers Indexes (PMIs) trough around 30. Fiscal stimulus mitigates but cannot prevent an inevitable rise in global unemployment. But a peak in the spread of the virus is achieved early in the third quarter (around July).

A global return to work during the third quarter underpins a sharp recovery in growth in the fourth quarter, before a strong recovery in 2021. This is probably best thought of as a U-shaped recovery, where there is only a moderate permanent loss of output. Typical of supply-chain shocks (rather than demand shocks), economies rebound strongly, aided by the massive fiscal and monetary support that has been added in 2020. Conversations about rising inflation do not gain momentum until 2022.

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In this scenario, equity markets probably rebound solidly by the end of 2020. After a 20 per cent to 30 per cent decline in earnings in 2020, the return of growth and earnings visibility underpins expectations for 20-30 per cent earnings growth in 2021, also allowing some modest valuation expansion. Central banks would continue to keep policy rates anchored near zero, and quantitative easing (QE) policy would limit any material yield curve steepening until mid-2021 at the earliest.

V-shaped recovery

This is the upside scenario, with a 30 per cent probability. The disease’s spread is contained more rapidly than expected in most countries during the second quarter. This is the V-shaped recovery with limited permanent loss of output.

Data for the second quarter contracts sharply across the world. But governments make pre-emptive decisions to open economies and restart activity to minimise the economic costs of the crisis. In this scenario, fiscal policy can more significantly bridge the gap in activity and lead to only a more moderate rise in unemployment.

As in the central case, growth rebounds sharply – but through both the third and fourth quarters with a similarly strong outcome for 2021. Stimulus sustains growth for several years and conversations about rising inflation gain momentum during 2021.

In this scenario, market performance would be similar to the first scenario, though the equity rebound could be materially stronger, and 2021 could see indices return to pre-COVID-19 levels. While policy rates would remain near zero, central banks would probably allow some drift up in bond yields in the first half of 2021.

L-shaped recovery

This is the downside scenario, with a 20 per cent probability. Here the spread of the disease is harder than expected to contain, and "peak disease" occurs only in early 2021. The long shutdown of activity sees a deep recession (bordering on depression) that extends into the first half of next year.

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Recovery only emerges from mid-2021. The depth of the crisis, and slow recovery, is hampered by significantly elevated unemployment (10 per cent to 20 per cent) and loss of human capital, as well as greater insolvency and long-term debt workouts. Policymakers are constrained in their ability to further support activity due to slow growth, low inflation and weak consumer and corporate sentiment.

In this scenario, the correction in equity prices is deeper than the first two scenarios, and any rise in equity indices is more sluggish and drawn out. Earnings could potentially fall 40-50 per cent in 2020 before recovering 10-20 per cent in 2021. Index levels may not return to pre-COVID-19 levels until after 2021. Policy rates would stay near zero and curves would be relatively flat for the entire 2020-21 period.

Managing through central case scenario

Much uncertainty remains about the outlook. We made a number of decisions through March to protect portfolios and position for an eventual recovery, particularly given our constructive view on growth and the outlook for markets through the second half of this year. This was primarily by moving underweight credit early in March, and by closing our underweight to domestic equities.

While the first half of this year will contain challenging economic data, an inevitable rebound in activity (be that mid-year or a little later), underpinned by an increasingly historic policy stimulus, should deliver a rebound in risk appetite in time. Reflecting that, and without material new information, we expect to maintain our preference for the key asset classes as equities, alternatives and fixed income on a one- to two-year outlook.

We continue to monitor key signals to guide us closer to when markets may trough. These include a peak disease spread or a vaccine, Russia and OPEC re-establishing constructive talks on oil, significant monetary and fiscal responses, investment-grade credit spreads re-tightening and equity markets approaching prior points of valuation support.

Over the past couple of weeks, a number of these have been ticked off, namely policy stimulus, while we have made progress on valuation, a re-tightening of credit spreads and weak data. At this stage, however, we are yet to achieve "peak disease", which appears the most critical for markets, to the extent it affects whether the outlook is a U-, V- or L-shaped recovery.

More than 10,000 people poured into the nation's capital on the ninth day of protests over police brutality, but what awaited them was a city that no longer felt as if it was being occupied by its own country's military.